Individual Tax Consequences of Investment Activity

1. Individual Tax Consequences of Investment Activity • Timing issues in income recognition • Expenses related to investment activity • Tax basis of investment assets • Gain/loss on disposition • Character of gain or loss • Capital gains tax rates for individuals • Limits on deductibility of passive activity losses • Wealth transfer taxation

2. Income Recognition • General rule: interest/dividend income taxable when actually or constructively received • Exceptions: municipal bond interest, return-of-capital dividends, discounts on short-term bonds, market discount on long-term bonds • Original issue discount on long-term bonds taxed as effective interest income over life of the bonds • Proceeds of life insurance policies • Liquidation prior to death is taxable, in excess of premiums paid • Death benefits not taxable

3. Investment Expenses • Expenses such as safety deposit box rental, investment management fees, subscriptions to investment newsletters are miscellaneous itemized deductions, deductible only to the extent that total exceeds 2% of AGI • Investment interest expense • Not deductible if proceeds used to purchase tax-exempt bonds • If used to purchase other investment property, itemized deduction cannot exceed taxpayers net investment income

4. Tax Basis of Investment Property • Initial tax basis generally equals cost plus acquisition fees • Basis adjustments: • Basis in bonds increased for taxable OID • Basis in securities increased (decreased) by dividend reinvestments (return of capital distributions) • Basis in partnership and S corporation investments adjusted to reflect allocations of income and expense, contributions and distributions • Basis in rental property reduced by annual cost recovery deductions

5. Sales of Investment Property • If investor holds several blocks of identical securities, acquired at different prices, and sells a portion of shares owned, basis is assigned using FIFO unless shares sold can be specifically identified • Sales of mutual fund shares typically use an average basis method

6. Gain/Loss on Disposition of Investment Property • Each gain/loss categorized as: capital, ordinary, Sec. 1231 • Capital gain/loss further categorized as short-term (assets held 1 year or less), long-term (assets held more than one year), 28% gain (collectibles), or 25% gain (unrecaptured Sec. 1250 gain) • Gains and losses within each category are combined to obtain a net gain or loss

7. Netting Rules for Capital Gains/Losses • If any capital category has a net loss, such loss can be deducted first against net 28% gains, then against other gains • An individual taxpayer’s overall net capital loss is deductible only up to $3,000 annually, as a deduction ‘for’ AGI • Any non-deductible net capital loss can be carried forward • Net capital gains taxed at special tax rates

8. Capital Gains Tax Rates • Excess of net short-term capital gains over net long-term capital losses taxed as ordinary income • Excess of net long-term capital gains over net short-term capital losses: • 28% (25%) gains taxed at maximum of 28% (25%) or taxpayer’s ordinary income tax rate • Other long-term capital gains taxed at 15% (NEW LAW – formerly 20%). However, if taxpayer’s ordinary income tax rate is 15% or less, long-term capital gains are taxed at 5% (NEW LAW – formerly 10%).

9. Special Rules Affecting Gain/Loss on Investments • Individuals may exclude 50% of gain on qualified small business stock held more than 5 years • portion of gain recognized is 28% gain • stock must be issued directly by a qualifying small business (< $50 M gross assets) after 8/10/93 • Loss on sale of Sec. 1244 stock deductible as ordinary • annual limit of $100,000 (MFJ) or $50,000 (single) • First $1 M of stock issued directly by corporation to investors for money or other property

10. PAL Limitations - Overview • Apply to individuals, fiduciaries, closely-held and personal service corporations • Income/loss separated into baskets • active (including compensation), portfolio, passive • Losses from passive activities can offset income from other passive activities • Net passive activity losses cannot offset active or portfolio income, until the taxpayer completely disposes of the passive activity

11. Definitions • Passive activity loss - net loss for the taxable year from all passive activities • Passive activity - two types: • Any trade or business in which the taxpayer does not materially participate • Any rental activity • Material participation: Taxpayer must be involved in the operations of the business on a regular, continuous, and substantial basis (based on facts and circumstances)

12. PAL Rules for Interests in Passthrough Entities • Classification of income and deductions as active/passive made at partner or shareholder level • Limited partners cannot, by law, materially participate • General partners and S corporation shareholders may treat their share of entity business income as active only if they materially participate in the business operations of the entity

13. Dispositions of Passive Activities • Any suspended losses from a passive activity are fully deductible in the year in which the entire interest is disposed of in a taxable transaction • Partial dispositions or dispositions in nontaxable transactions do not trigger suspended losses

14. Special Rules for Rental Real Estate • Individuals can deduct up to $25,000 annually of rental real estate losses if: • AGI is less than $100,000 (allowance reduced by 50% for AGI in excess of $100,000) AND • Taxpayer actively participates in the rental activity • Owns at least a 10% interest • Is significantly involved in the management of the property (approves tenants, sets lease terms, authorizes repairs, selects management service)

15. Wealth Transfer Planning • Gift, estate, and generation skipping transfer taxes • The unified gift and estate tax is based on cumulative transfers over time (life + death). • Graduated rates up to 55% • Under new law, maximum rate drops to 45% by 2007. In 2010, maximum gift tax rate drops to 35%, and estate tax is eliminated (BUT it returns in 2011!)

16. Lifetime Transfer Tax Exclusion • Gift tax exclusion $1 million • Estate tax exclusion • 2002 and 2003 $1 million • 2004 and 2005 $1.5 million • 2006, 2007, and 2008 $2 million • 2009 $3.5 million • Estate tax eliminated in 2010 • Estate tax reinstated in 2011 with exclusion of $1 million • Estate tax exclusion reduced by any lifetime gift tax exclusion used during decedent’s life

17. Gift Tax • Remember, all receipts of gifts are excluded from INCOME taxation • We are now discussing GIFT taxation • Gift tax paid by the giver, not the recipient • Can exclude $11,000 per year per donee from taxable gifts • Can treat gift by one spouse as made 1/2 by other spouse • No gift tax on gifts to spouse, charity, paying tuition or medical costs

18. Income Tax Effects of Gifts • Gift is not taxable income to recipient • Donor’s adjusted basis in the property carries over to become the recipient’s basis • exception - use FMV if less than adjusted basis • After gift, any income derived from the property belongs to the recipient

19. Estate Tax • Taxed at unified estate and gift rate schedule • FMV of estate is taxed • Unlimited marital deduction • Reduce estate by taxes, charity, administrative expenses

20. Income Tax Effect of Bequests • Receipt of a bequest is not taxable income to heir • Basis of inherited property = FMV at date of death • Free income tax step-up in basis • Trade-off: • Gift now at low basis, avoid some transfer tax • Keep and include in estate, but heirs get high basis